7/28/2019 Rebalancing Your Portfolio on Time

1/3

So you've established an asset allocation strategy that is right for you, but atthe end of the year, you find that the weighting of each asset class in your portfolio has changed! Whathappened?Over the course of the year, the market value of each security within your portfolio earned a differentreturn, resulting in a weighting change.

Portfolio rebalancing is like a tune-up for your car: it allows individuals to keep their risk level incheck and minimize risk.

What Is Rebalancing?Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight ofeach asset class back to its original state. In addition, if an investor's investment strategy or tolerance forrisk has changed, he or she can use rebalancing to readjust the weightings of each security or assetclass in the portfolio to fulfill a newly devised asset allocation.

Blown Out of ProportionThe asset mix originally created by an investor inevitably changes as a result of differing returns amongvarious securities and asset classes. As a result, the percentage that you've allocated to different asset

classes will change. This change may increase or decrease the risk of your portfolio, so let's compare aRebalanced portfolio to one in which changes were ignored, and then we'll look at the potentialconsequences of neglected allocations in a portfolio.

Let's run through a simple example. Rajveer has $100,000 to invest. He decides to invest 50% in a bondfund, 10% in a Treasury fund and 40% in an equity fund.

At the end of the year, Rajveer finds that the equity portion of his portfolio has dramatically outperformedthe bond and Treasury portions. This has caused a change in his allocation of assets, increasing thepercentage that he has in the equity fund while decreasing the amount invested in the Treasury and bondfunds.

7/28/2019 Rebalancing Your Portfolio on Time

2/3

More specifically, the above chart shows that Rajveers $40,000 investment in the equity fund has grownto $55,000, an increase of 37%! Conversely, the bond fund suffered, realizing a loss of 5%, but the

Treasury fund realized a modest increase of 4%. The overall return on Rajveers portfolio was 12.9%, butnow there is more weight on equities than on bonds. Rajveer might be willing to leave the asset mix as isfor the time being, but leaving it too long could result in an overweighting in the equity fund, which is morerisky than the bond and Treasury fund.

The Consequences ImbalanceA popular belief among many investors is that if an investment has performed well over the last year, itshould perform well over the next year. Unfortunately, past performance is not always an indication offuture performance - this is a fact many mutual funds disclose. Many investors, however, remain heavilyinvested in last year's "winning" fund and may drop their portfolio weighting in last year's "losing" fixedincome fund. Remember, equities are more volatile than fixed income securities, so last year's large gainsmay translate into losses over the next year.

Let's continue with Rajveer's portfolio and compare the values of his rebalanced portfolio with the portfolioleft unchanged.

At the end of the second year, the equity fund performs poorly, losing 7%. At the same time the bond fundperforms well, appreciating 15%, and Treasuries remain relatively stable with a 2% increase. If Rajveerhad rebalanced his portfolio the previous year, his total portfolio value would be $118,500, an increase of5%. If Rajveer had left his portfolio alone with the skewed weightings, his total portfolio value would be$116,858, an increase of only 3.5%. In this case, rebalancing is the optimal strategy.

7/28/2019 Rebalancing Your Portfolio on Time

3/3

However, if the stock market rallies again throughout the second year, the equity fund would appreciatemore and the ignored portfolio may realize a greater appreciation in value than the bond fund. J ust aswith many hedging strategies, upside potential may be limited, but, by rebalancing, you are neverthelessadhering to your risk-return tolerance level. Risk-loving investors are able to tolerate the gains and lossesassociated with a heavy weighting in an equity fund, and risk-averse investors, who choose the safetyoffered in Treasury and fixed income funds, are willing to accept limited upside potential in exchange forgreater investment security.

6 portfolio rebalancing rules

Here are six crucial rebalancing rules, according to the American Association of Individual InvestorsJ ournal.

1. Annual Rebalancing2. Don't stray too much3. Minimum commitments4. Discipline5. Don't get greedy

6. Focus on the long term

ConclusionRebalancing your portfolio will help you maintain your original asset-allocation strategy and allow you to

implement any changes you make to your investing style. Essentially, rebalancing will help you stick to

your investing plan regardless of what the market does.